Growing pains or gains for the EU Green Deal

The financial industry has undergone significant changes since March 2021, particularly with the implementation of the EU’s Sustainable Finance Action Plan. This plan aims to redirect capital toward sustainable investments, mitigate ESG risks in financial markets, and increase transparency and long-term thinking. To move sustainable investing forward, it’s important for more companies to report their sustainability efforts consistently.

Tom Renders, partner from Deloitte Belgium spoke with Marie Lambert, Professor of Finance at HEC Liège, Management School of the University of Liège, to talk about these changes and the ways that the industry has responded to them.

Tom Renders: Hi Professor Lambert, first of all, many thanks for your collaboration on this interview. Over the past two years, the investment management landscape changed drastically, often driven by regulatory changes and, to a large extent, by the European Union’s increasing focus on sustainability. How would you summarize this evolution?

Marie Lambert: Since March 2021, the financial landscape has indeed profoundly changed. The EU’s Sustainable Finance Action Plan, which is part of the EU Green Deal, has established a series of actions to reach three objectives: (i) redirect cash flows to sustainable investments, (ii) protect financial markets from environmental, social or governance (or ESG) risks, and (iii) promote information transparency and long-termism. To support these actions, new regulations and directives were designed and implemented in 2021-2022.

First, since March 2021, financial market participants have classified their financial product offerings to better inform investors about the sustainable objectives of their product (the so-called Articles 6, 8 and 9), the management of ESG risks and the due diligence carried out to avoid adverse impacts on society.

Second, since 1 January 2022, the EU Taxonomy was implemented, which establishes a dictionary of green activities related to six environmental objectives. Financial and non-financial companies under the scope of the Non-Financial Reporting Directive (NFRD) need to disclose the proportion of eligible activities on climate objectives. Full reporting regarding alignment has been postponed to 2023 for financial undertakings. Additional information on taxonomy-aligned investments is also required for financial products classified as “sustainable”. Last but not least, the future Corporate Sustainability Reporting Directive (CSRD) should extend the number of companies required to report sustainable information in a more standardized way.

Tom Renders: You mentioned the Sustainable Finance Disclosure Regulation (SFDR) and its related product classifications. How important is the increase in 'green' investments compared to, let’s say 3 years ago?

Marie Lambert: According to the Global Sustainable Investment Alliance (GSIA), sustainable investments had reached $30.7 trillion at the end of 2017. In 2019, three years later, the value increased to $35.3 trillion. This represented one-third of the global assets under management. If we assume the same proportion in 2025, given the expected growth in global AUM from various professional sources, we could expect global sustainable investments to increase to above $50 trillion. In Europe, we observe, in the same period, some downward corrections in anticipation of the new regulatory framework, which has clarified the scope for sustainable investment funds.

Between 2018 and 2022, HEC Liège’s own research observes five times more dollar flows for funds classified in Article 9, than for those classified in Article 8. Compared to unclassified funds under SFDR, Article 9 funds receive $2.75 million more investment flows, while Article 8 funds attract only $0.5 million more capital.

Regarding SFDR classification, in December 2022, MSCI categorized 25% of funds in one of the three SFDR Articles, which is 5% higher from 6 months prior. Of the classified funds, more than 70% of investment funds marketed in EU are classified as either Article 8 or 9 (with Article 9 representing less than 10%). The Morningstar database counts Article 8 and 9 funds as more than 50% of the market share. Yet, the average ESG ratings do not significantly vary among the different groups of funds. For instance, considering the global ESG rating, on a scale from 0 to 10, we observe average values of 7.86, 8.27, 8.76 for funds classified in Article 6, 8 and 9, respectively.

Tom Renders: Performance and risk-return are often the determining factors in the selection of investment products. It is precisely this relationship that is often questioned in sustainable investments. Is this a fair observation?

Marie Lambert: Recent academic studies have shown that although sustainable ratings are used by investors, the main criterion remains the risk-return performance ratio. The utility function of investors, which – in the academic jargon – describes the investor level of satisfaction regarding an investment, has traditionally relied exclusively on the expected return and risk from the investment. Studies have shown that some (but not all) investors exhibit preferences regarding sustainability that should be integrated as an additional criterion in the function. Because of the heterogeneous preferences among investors, we observe pressures for the demand of “sustainable” assets, which results in higher pricing and a drag in return. The lower demand for so-called sin stocks could lead to their underpricing, with opportunities for making abnormal return. Another explanation could be that investors require a premium to keep those assets out of institutional portfolios.

Yet, we have recently experienced two very particular periods: First, the period of 2020 - 2021 has shown very strong performance achieved by high ESG assets, mostly due to a shock in the demand for investments and products that hedge climate or social concerns. Second, the energy crisis of 2022 has benefited the energy sector.

Both examples remind us that the market price is determined by the law of supply and demand. Pricing pressure can come from either high demand or limited supply.

Tom Renders: You made an interesting point about sin stocks. What can be said about the recent hype around sin-funds?

Marie Lambert: The first complete academic study focusing on sin stocks was published in 2009 in the Journal of Financial Economics by Hong and co-authors¹. It documents an average outperformance of sin stocks (i.e., stocks of firms active in the beer, smoke or gaming industry) of 26 bps per month in the US market from 1962 to 2006. The main argument to justify this outperformance proposed by the authors, is that these stocks are neglected and face litigation risk. Thus, this additional risk should be compensated by higher returns.

At HEC Liège, we reproduced their methodology in the period of 2007-2022 and we find that the alpha is no longer significant.

Still, we can recently see a hype around sin-funds. This can be illustrated, for instance, in the launch of a “bad ETF” in 2021 that allowed investors to get exposure to industries related to gambling, alcohol, drugs or ETFs. Another example is the tendency for some funds to overweight their investment in the energy sector, which has outperformed in this energy crisis. As explained earlier, the energy crisis of 2022 reminds us that fundamentals in market pricing are still driven by laws of supply and demand. And the energy sector was generating strong returns, as energy was a very expensive and scarce good.

Tom Renders: Going back to SFDR, we can observe that the largest increase in sustainable funds in Article 8 or 9 is the result of an adjustment of the investment policy of existing funds. How reliable are the track records of such funds? How should investors navigate this area?

Marie Lambert: The attribution of past performance to the fund SFDR classification must be made with caution. Two problems limit this performance analysis.

First, one year after the classification, we observed many upgrades and downgrades. As an example, Amundi has recently downgraded most of their Article 9 funds to Article 8 funds. Given the different interpretations around the SFDR classifications, it is not surprising to see these adjustments and I expect more adjustments once the second level of the SFDR regulation including quantitative reporting on principal adverse impacts and taxonomy-alignment indicators will be released for Articles 8 and 9 funds.

Secondly, according to Becker et al. (2022)², European funds have recently increased their ESG efforts as a way to attract new inflows and to comply with new regulations. However, the classification does not tell us which strategy the funds were performing before the classification and that can cause problems to measure performance across categories.

Tom Renders: There is some talk about an ESG bubble. To what extent is this a realistic fear today and when looking towards the future? Are we already seeing signs of this in the market today?

Marie Lambert: In efficient markets, all information should be integrated in the price and so we should not observe any under- or overpricing. We are currently in the transition phase where information on ESG is limited to a selected small sample of companies. This might create an imbalance between offer and demand and push valuations to abnormal levels. This abnormal situation should get resolved over time, as we get access to more information and investor preferences get more homogenous. If we compare the valuation of companies in the Stoxx 50 to those in the Stoxx 50 ESG, the (EBITDA, EBIT and revenue) valuation multiples of stocks included in the ESG group are not significantly different from those in the other group of stocks.

Tom Renders: Investors, and certainly institutional asset owners, are becoming increasingly cautious about their investment portfolios. If an ESG approach is applied, it usually consists of a combination of best-in-class approach and exclusion. As a result of the latter, the most controversial companies and sectors are increasingly losing support from investors and the communication between investors and companies is declining. In short: Are the biggest 'culprits' not being robbed of their opportunity to improve themselves? Is the regulation falling short here?

Marie Lambert: Corporate engagement and shareholder action remains a third sustainable investment strategy (GSIA, 2020)³. While we acknowledge that asset owners, such as pension funds and insurance companies might represent minority shareholders and, therefore might either not play an active role or might delegate the task, then there is probably a paradox with regard to the current situation. Some of these institutional investors are afraid of being accused of greenwashing, and prefer to exclude some sectors. However, investing in browner issuers might be justified if the goal is to use shareholder proxy voting rights to encourage them to change their practices. Regulation is not falling short, but the problem is rather coming from market pressure: public opinion might impact how asset managers will choose to react.

¹ Hong, H., & Kacperczyk, M. (2009). The price of sin: The effects of social norms on markets. Journal of Financial Economics, 93(1), 15-36.

² Becker, M. G., Martin, F., & Walter, A. (2022). The power of ESG transparency: The effect of the new SFDR sustainability labels on mutual funds and individual investors. Finance Research Letters, 102708.

³ GSIA Global Sustainable Investment Alliance. (2020). Global Sustainable Investment Review 2020. Retrieved from http://www.gsi-alliance.org/wp-content/uploads/2021/08/GSIR-20201.pdf